Eye On Brazilian Policy: “Oh No You Didn’t”

Conclusion: We view the central bank’s aggressive and proactive rate cut as supportive of Brazilian equities because it will likely coincide with a peaking of CPI and a deceleration in Brazil’s current economic slowdown. Our quant models aren’t in full confirmation of this, however, which suggests the turn is likely further out in duration. From a longer-term perspective, Rousseff’s recently unveiled 2012 budget proposal is flat-out awful for the Brazilian economy.

Yesterday evening, Banco Central do Brasil’s monetary policy committee (COPOM) “surprised” economists by cutting the country’s benchmark interest rate, the Selic, -50bps to 12%. We used quotations around the word surprised because the move wasn’t very surprising at all. Brazil’s bond market, interest rate swaps market, and, perhaps most importantly, Brazilian officials have been signaling to us for at least the last the last few weeks that a rate cut was definitely in play – despite the fact that the country’s latest CPI reading came in at a six-year high of +6.9% YoY (40bps above the upper threshold band around the central bank’s target of +4.5%).

As we pointed out in our Weekly Latin America Risk Monitor on August 22nd:

On the political pressure front, we offer the following collection of recent quotes and sound bites originating from Brazilian policymakers if nothing more than to highlight how telegraphed and politically motivated last night’s rate cut decision was:

“Creating conditions to cut interest rates in Brazil is a priority… Lower rates would be very healthy because they would cut the cost of servicing the nation’s debt.” – Finance Minister Guido Mantega on Aug. 23.

“Brazil plans to halt a rise in government spending this year to prepare Latin America’s biggest economy for a global slowdown and make room for a cut in interest rates… As you reduce or stop increasing public spending, you open space for a reduction in interest rates when the central bank thinks it is possible.” – Finance Minister Guido Mantega on Aug. 29. (to Matega’s credit, Brazil did recently revise up its target for its 2011 primary surplus +11.4% to R$91B ($57B), though largely on aggressive measures to widen the tax base among consumers and corporations alike – as opposed to more traditional measures of austerity)

“The country’s interest rates should begin to fall as the government reduces spending… We want, starting now, to have lower interest rates on the horizon.” – President Dilma Rousseff on Aug. 29

“Brazil is anxiously awaiting a decline in the country’s interest rates… We are all anxious to see the moment when the rate of interest will drop... The government’s fiscal efforts may create the conditions for rates to fall in the very near future.” – Trade Minister Fernando Pimentel on Aug 30.

Needless to say, the central bank’s autonomy is being called into question. While this is certainly not the forum to debate the proper relationship between officials who determine monetary policy and those that determine govern the broader economy, the interplay in Brazil is one worth highlighting. To that tune, check out the notes regarding this subject below, which were compiled from various sources in the Brazilian press by Moshe Silver, Chief Compliance Officer and Managing Director here at Hedgeye:

President Rousseff and her PT party hailed the rate cut, PSDB party opposition politicians say the central bank was afraid of President Rousseff and caved in to her politicized demand.

Former central bank president Carlos Langoni says the COPOM decision is a “daring” move that calls the central bank’s credibility into question and needs to be much better explained.

Yesterday’s COPOM meeting dragged on for an unusually long four hours, and two directors voted against the decision.

It will be interesting to see whether or not Tombini and his divided board are jumping the gun. As we alluded to earlier with headline CPI currently running at a six-year high, inflation is not tamed within Brazil. Moreover, the most recent inflation-related data points would suggest that price pressures could indeed be increasing on the margin: 1) IBGE IPCA-15 CPI accelerated in Aug. to +27bps MoM; and 2) FGV IGP-M CPI accelerated in Aug. to +44bps MoM. We do, however, expect YoY headline CPI to peak in August and begin slowing like the most recent IGP-M print, which decelerated to +8% YoY (vs. +8.4% prior). Tombini’s models echo that of our own, saying recently, “Policymakers are more comfortable with inflation because annual price increases will slow starting in September.”

It certainly is unusual for a central bank to be this aggressive – particularly when the data has not yet confirmed their outlook. Specifically, the last time the global economy was this close to the precipice, Banco Central do Brasil waited patiently for confirming data to cut interest rates (over four months after the collapse of Lehman Bros). Interestingly, President Rousseff said in early Aug. that the Brazilian economy was “stronger that it was at the time of the Lehman bankruptcy” and that the country has “the necessary conditions to meet the global economic crisis”. Given yesterday’s aggressive maneuver out of the Brazilian central bank, perhaps they believe the Global Macro environment will deteriorate faster than they had originally anticipated and far worse than what we saw in the Lehman aftermath. Something to keep in mind there as it relates to “what people are saying out there”…

Their aggressiveness this time around could be a good thing or it could be a bad thing, particularly if inflation expectations increase and push up the long end of Brazil’s interest rate curve – which it did not do today (in fact, Brazil’s benchmark 9yr bond yield has fallen -17bps day/day). Regardless, we commend Banco Central do Brasil for having conviction in their process and being daring enough to step outside the box and help the ailing Brazilian economy with an “unsuspected” rate cut. Furthermore, analysis of their accompanying statement would suggest that they truly believe a rate cut was warranted – as opposed to being merely politically motivated:

“Re-evaluating the international scenario, the Copom considers there was a substantial deterioration consisting of, for example, a generalized reduction of great magnitude in the growth projections for the principal economic blocs.”

“It also notes that, in these economies, the space to use monetary policy is limited and the outlook is one of fiscal restrictions. “

“In this way, the Committee evaluates that the international scenario shows a disinflationary bias in the relevant time period.”

It is important to highlight how their outlook for the global economy stands counter to the bullish storytelling within our domestic institutional investment community.

As it relates to the Brazilian economy at large, it will be interesting to see if this is an inflection point in Brazil’s economic cycle or merely a catalyst for a deceleration in the current slowdown. Our models point to the latter, and that may explain why the Bovespa index is still broken from a TREND and TAIL perspective, despite a +14.4% melt-up “off the lows”. It will pay to wait to see if the Bovespa breaks out and holds above its critical TREND line of resistance. If that happens, we think this market trades between 59,765 and 66,303 over the intermediate term. A breakout above the TAIL line would be incredibly bullish indeed and would likely coincide with more aggressive rate cutting.

On the subject of cutting, Brazilian policymakers “did it again” with regards to hyping up budget cuts and falling well short of the expectations they set with the Brazilian public. Yesterday, President Rousseff’s 2012 budget proposal was introduced and, needless to say, it’s rife with accounting tricks and aggressive assumptions that makes the administration appear more fiscally conservative than it is actually being.

In fact, this budget is actually seeking to “increase” the country’s primary surplus to R$140B from the projected R$128B. This does, however, include an accounting buffer that will allow it to discount R$40B, per Budget Minster Miriam Belchior. Without the accounting buffer, which Belchior publicly admits the administration would prefer not to use, the country’s primary surplus is expected to decline -21.8% next year.

We’ve been very critical of her administration’s budgeting gimmicks in past notes, so, for now, we’ll grant her the benefit of the doubt and reserve the bulk of our judgment for when/if the budget is actually ratified by the Brazilian Congress. Were the budget to become enacted as it stands currently, we believe it would be bearish for the country’s real economic growth over the long-term TAIL (higher rates of inflation).

All told, we view the central bank’s aggressive and proactive rate cut as supportive of Brazilian equities because it will likely coincide with a peaking of CPI and a deceleration in Brazil’s current economic slowdown. Our quant models aren’t in full confirmation of this, however, which suggests the turn is likely further out in duration. From a longer-term perspective, Rousseff’s recently unveiled 2012 budget proposal is flat-out awful for the Brazilian economy.

Darius Dale

Analyst

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09/01/11 03:54 PM EDT

DNKN: TRADE UPDATE

DNKN was shorted this afternoon in the Hedgeye Virtual Portfolio.

DNKN is performing strongly today, up around 2% as we head towards the close. Keith shorted the stock based on his quantitative model but we also remain bearish from a fundamental perspective. We believe that the stock is egregiously overvalued, as we wrote on 8/22. Investors buying DNKN today are paying a steep premium to SBUX, MCD, and YUM. We do not believe that is a good deal! Within the QSR space, only GMCR and CMG are awarded richer multiples by the Street.

There are two events tomorrow that we think you should be aware of. First, the Street initiates coverage tomorrow so we anticipate quite a lot of interest in the name (on a relative basis, of course, given the holiday weekend). Second, we are catching up with the management team tomorrow in order to learn more about their growth strategy and other aspects of the business. We will be posting any important takeaways from the call.

As the chart below shows, the immediate-term TRADE lines of support and resistance are $25.03 and $27.11, respectively.

Howard Penney

Managing Director

Rory Green

Analyst

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09/01/11 02:53 PM EDT

JCP: Covering TRADE

Keith is booking another gain covering JCP in the Hedgeye Virtual Portfolio with the stock immediate-term TRADE oversold according to his model. We remain bearish on the stock over the intermediate-term.

While still early in the quarter, August sales came in very light this morning -1.9% (vs. +1.7%E) supporting our below consensus numbers. The Street is currently expecting flat sales in the 2H on LSD comps. We’re modeling sales down -1% and -3% on comps of +1% and -1% in Q3 and Q4 respectively.

Keep in mind, the company had several new introductions last year in Q3 (LIZ excl, Mango, Modern Bride) that they have to lap in addition to catalog sales rolling off. We’re expecting sales from existing stores to be down -$180mm in addition to the negative drag from the catalog business to the tune of $200-$260mm coming out in the 2H. With pressure on growth from existing stores coupled with catalog sales coming off, JCP will be significantly challenged to meet the Street’s sales expectations over the intermediate-term.

As for the headline regarding the company selling outlet stores that just hit the tape - it's old news and inconsequential to the bigger call here.

At $1.60 for the year, we remain 10% below consensus and bearish on the stock over the intermediate-term.

For more info on our thesis, see our Black Book, “JCP: What Ackmanists Are Missing.”

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09/01/11 02:03 PM EDT

Europe by the Charts

Positions in Europe: Short UK (EWU); Covered EUR-USD (FXE) on 8/31 in the Hedgeye Portfolio

Below we call-out four charts of the day: European Manufacturing PMI; Eurozone Confidence; Italian/German government yield spread; and the CHF vs EUR and USD.

European Manufacturing PMI Sinks

Of the countries reporting Manufacturing PMI, there’s a clear downturn in the August numbers, a trend we’ve been following for the last six months. 8 of the 15 countries recorded figures below 50, which indicates contraction (see chart below). And short of the Czech Republic, Norway, and Denmark, the remaining countries are dancing on the 50 line. We’re convinced Eastern Europe’s growth outlook can’t improve before the core of Europe improves (due to heavy trade reliance), and we see the core dragged down by sovereign debt leverage of the periphery, banking risk, and slowing growth in the US over the intermediate to longer term durations.

Eurozone Confidence Crumbles

It follows that given sovereign debt contagion across the region confidence will erode. We continue to highlight the threat of a French credit rating downgrade, which we’ve monitored via rising CDS spreads (up +100bps since a low in April), for its impact on the EFSF. Confidence has trended down since February of this year. We see plenty of downside room to run from here with significant white space (= uncertainty) between now and the late September/early October decision on the terms of the EFSF, which don't include increasing its size from €750B. We think the facility needs to be expanded to at least €2T, a large order given Germany would back the lion’s share of it.

Bad Boy Berlusconi

Italy and Spain are two countries in Europe we’re closely watching because 1.) Their economies are far larger than Greece, Ireland and Portugal and present must greater risks from a sovereign and banking perspective, 2.) Should either country need “bailout” assistance the EFSF is underfunded and there’s no indication Trichet wants the ECB to directly take on "more" region-wide balance sheet exposure.

German yields have come in notably ytd (-79bps), and therefore the country still remains the region’s beacon of stability, while its equity market has been crushed (DAX down -19% in August alone). Given that Merkel is pumping up against two more State elections (in September) and floundering confidence even among her party, it’s far from a foregone conclusion that Germany will sign any and all blank checks to bailout or support its neighbors. Frankly, we’re worried that the once perceived stronger peer nations (of France and Italy) may be in no shape to contribute to bailing out the region if tipping points are achieved in those countries.

One kink in the chain came on Tuesday when Berlusconi announced that the country’s €45 Billion austerity package will be pruned. The new version removes the Solidarity tax , which placed an additional 5% tax on annual incomes above €90K, and the original proposal to cut €9B in funding to regional and local governments was trimmed by €2B. At a time when fat (debt) is expected to be reduced, pruning the austerity package heightens the risk of investor sentiment turning negative.

Swissy Back on the Juice

With the Swiss National Bank (SNB) refraining from announcing further steps to weaken the CHF versus major currencies and today's announcement by the government of an 870 million Franc ($1.1 Billion) economic stimulus package to support tourism and exports (still to be approved by parliament in September), there looks to be more room to run in the CHF vs the EUR and USD from here, especially as there’s no indication Europe has command of the run-away sovereign debt contagion threats that have plagued the region for the last 18 months.

It’s worth noting that there’s already much domestic consternation on the government’s stimulus package, which includes 500M CHF to protect jobs in all industry sectors, with most cash being used to extend the exiting shortened working hours scheme and 100M going to a fund that extends emergency assistance to the hotel industry. Push-back includes the ultimate size of the package, off the original 2B CHF proposed in August, and the government’s ability to properly allocate funds, meaning some enterprises will benefit while others will not receive assistance.

All in, we think the flight to the safety trade remains intact.

Matthew Hedrick

Senior Analyst

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09/01/11 11:49 AM EDT

TGT: Virtual Portfolio Update

Keith added Tar-gey, one of our highest conviction TAIL ideas, into the Hedgeye Virtual Portfolio. Good numbers this morning show that the company continues to execute around the Street's immediate-term concerns.

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09/01/11 10:58 AM EDT

Retail: Get Ready for Q3

This morning’s sales reports were choppy as was expected with the concoction of BTS, Irene, and the start of more challenging 2H compares all taking hold. Not surprisingly, with only one month of Q3 now in the books there was little color on any change to internal full-year outlooks, or margins, but the same number of companies beat on the sales line as missed and sales decelerated on both a 1yr and 2yr basis for the second consecutive month. This is not good for one of retail’s most crucial selling seasons and suggests early confirmation of our view that Q3 earnings season is setting up to be the worst in two-years.

On the whole, BTS commentary was unremarkable (TGT good, JCP poor) while surprisingly few retailers highlighted Irene among the key reasons for lighter sales (JCP was one of them). That said, most retailers noted anywhere from a 0.5%-3% impact to comps from the storm. Interestingly, TGT noted a positive +0.5% benefit from the storm adding that the shift is likely to impact September by a like amount.

Our sense is that many retailers - especially on the discretionary side - are underestimating the percent of sales that are lost forever vs. pushed into September.

Discounters continue to be the strongest performing segment of retail. This is likely due to greater grocery exposure, which continues to be a key category. Retailers with exposure there (TGT up mid-teen, COST up LDD, & BJ) all came in well above expectations.

JCP was a clear negative callout again. The most notable callout in its report was e-commerce down -8%. The rate of underperformance in this category appears to be accelerating to the downside making it increasingly more difficult to meet top-line expectations. This is hardly a business that should be down for anybody - ever.

GPS was another negative callout with both domestic and international business down HSD. International was down 9% - this is supposedly their growth engine?

Lastly embedded in LTD’s solid sales report was La Senza (their higher end concept) coming in down -8% reflecting a sharp deceleration at the high end.

Shorts: JCP, JCP, and JCP. HBI, GIL, UA and COH

Longs: WMT, TGT, NKE, LIZ

Casey Flavin

Director

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